Aviva, the Norwich Union insurer, is paying a £400 million windfall - around half originally promised - to one million of its with-profits policyholders in a deal reached with Clare Spottiswoode, the Policyholder Advocate.

The drastically reduced hand out, made in return for policyholders waiving their rights to future payments from what is known as the "inherited estate" - the surplus withheld by the insurer in good years - emerged after Aviva reneged on a promise to pay £1 billion in February, blaming falls in the stock market for cutting the valuation of its funds.

Savers were originally offered an average payout of £1,000 but the offer was conditional on the FTSE 100 not slipping below 5,000 points. It had slumped to 4,164 points when the offer was withdrawn in February. The new deal hands savers in the CULAC and CGNU with-profits funds a minimum payment of £200 and Aviva said 90 per cent of eligible policyholders will receive between £200 and £1,150. If all policyholders agree to the deal, the average payment would be about £500.

Aviva is having to pay out much less than it originally expected because falls in the value of its investments mean the size of the inherited estate has shrunk from £2.1 billion in June last year to £1.4 billion at the end of March. The move comes as the Government was criticised today by Ann Abraham, the Parliamentary Ombudsman, for not setting up a compensation scheme for more than one million Equitable Life policyholders

Mark Hodges, chief executive of Aviva's life business said: "This is a good deal for our customers and shareholders. We've worked hard with Clare and her team to come up with a flexible offer."

Ms Spottiswoode said: "This is good news for policyholders after the turmoil in financial markets that affected the plan announced last year." However, Aviva warned that the final size of the payout will change to reflect rises or falls in the value of the inherited estate, with the final payment based on its average value over the three months from June to August this year.

Mr Hodges gave a presentation to Aviva shareholders today telling them that the payment will come from shareholder funds, leaving the inherited estate untouched, and freeing up £600 million from the estate to be used to underwrite new policies that do not allow policyholders to benefit from future distributions.

He said if policyholders choose not to accept the cash, but opt instead to continue to take their usual bonuses there would be "significant potential upsides" for shareholders.

The payment would in theory reduce the company's regulatory cash safety cushion, the IGD surplus, but Mr Hodges said that plans are already in place to offset the impact of the incentive payment by the time it is made. He said: "Around half of the impact will be mitigated through Aviva UK Life initiatives."

He said that this will include securitisations of some of its life assets, entering new resinsurance contracts and improving operating earnings. The remainder will come through other group actions. "We expect the transaction to improve the IGD surplus thereafter."

'We have announced today that we are going ahead with the reattribution of the inherited estate. Whilst markets mean that the payout will be lower, we believe that policyholders have a right to share in the benefits of the inherited estate. Each customer will be able to choose whether they wish to accept the cash payment - it will not be a majority vote.

"This is a deal that is beneficial both for our customers and our shareholders. Most importantly we have plans in place to ensure that the payments we make to the policyholders, alongside the actions on solvency, mean that there will be no adverse impact from this transaction on the group's solvency surplus.'

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